Pandora Sounds Good to Put Sellers

This play on P shares has a high probability of success

Pandora (NYSE: P) has returned to its winning ways of late, up 23% during the past month and moving almost 7.5% higher in Wednesday’s session alone. A USA TODAY article noted this week that Pandora’s business model is thriving despite a challenging economic environment. The online music service’s user base is around 125 million currently, up 66% from just a year ago. The average Pandora user now listens to the service for 18 hours each month.

Pandora’s bottom line looks impressive from an earnings perspective as well. In late November, the company announced revenue of $75 million, roughly double the previous year. Net profit was $638,000, up from a loss of $1.8 million one year prior.

Also giving the shares a boost yesterday was new broker coverage from Raymond James, which started Pandora with an outperform rating. Before Raymond James weighed in, P was already rated a buy or strong buy at 10 brokerage firms, with four naming the stock a hold and just two listing it as a sell, according to First Call.

The shares still have a relatively tough row to hoe, however, as P remains off about 25% since its June 15 initial public offering. That first day in the market, P shares closed at $17.42 after shooting to the $26 level right out of the gate. On the plus side, the equity still is above its initially expected IPO range, which was $10 to $12 per share.

Weighing all of this information — promising fundamentals, bullish analysts and short-term technical strength ­– some option traders took interest in P shares during Wednesday’s session. By the end of the day, about 8,000 contracts had changed hands on the stock, a large portion of which traded at the February 10 strike put. This particular put option saw nearly 3,300 contracts trade, compared to existing open interest (already-open options) of just 563. This suggests the options that traded were being opened rather than closed.

Shortly after the opening bell, one block of 2,225 contracts traded at this put strike for 25 cents each — overall, that single trade was worth more than $55,000 (2,225 contracts times 0.25 times a factor of 100, as each option contract represents 100 shares of the underlying stock). Based on the bid and ask at the time of transaction (20 cents and 35 cents, respectively), it appears these puts were initiated on the sell side.

Traders selling this February 10 put have an obligation to buy Pandora shares at this price at any time between now and the February options expiration (for as long as the option remains open). With the stock trading at $12.98, no one on the buy side of the trade would want to make this deal — after all, who would opt to sell a $13 stock for $10?

If the stock continues to trade above the $10 threshold through February expiration, the put will expire worthless, and the put seller keeps the premium collected for the trade (which in this case was a modest 25 cents per contract).

By the end of the session, the bid and ask price of this put had dropped to 15 cents and 20 cents (respectively). If the seller wanted, he could have turned around, bought the put back for the ask price of 20 cents in the open market, and have made a quick nickel in just one day ($11,000 after doing all the math).

Put selling also can be a way for traders to get “paid to wait” for a stock they’ve had their eye on to retreat to a more palatable level. In this scenario, for example, the trader is on the hook to buy P shares if the stock breaches the $10 price level, but maybe he is OK with owning the shares at that price point. And in the meantime, he can collect a bit of premium by selling puts.

The short put (specifically the cash-secured short put) is one of the most interesting strategies out there for beginning traders who want to hedge their portfolios. Learn more about this strategy here.

As of this writing, Alex Hanson did not hold a position in any of the aforementioned stocks.